1. 16-1 ©2008 Prentice Hall, Inc.

2. 16-2 ©2008 Prentice Hall, Inc. U.S. TAX OF FOREIGN- RELATED TRANSACTIONS  Jurisdiction to tax  Taxation of U.S. citizens & resident aliens  Taxation of nonresident aliens  Taxation of U.S. businesses operating abroad  Financial statement implications

3. 16-3 ©2008 Prentice Hall, Inc. Jurisdiction to Tax  U.S. authority to tax foreign-related transactions based on three factors  Taxpayer’s country of citizenship  Taxpayer’s country of residence  Location where the income is earned

4. 16-4 ©2008 Prentice Hall, Inc. Taxation of U.S. Citizens and Resident Aliens  U.S. citizens and resident aliens taxed on worldwide income  Income earned in foreign countries or U.S. possessions receives special treatment  Foreign tax credit  Foreign earned exclusion

5. 16-5 ©2008 Prentice Hall, Inc. Foreign Tax Credit (FTC) (1 of 4)  What taxes qualify for FTC?  Who is eligible for FTC?  How are taxes denominated in foreign currency translated into dollars?  FTC permits U.S. citizens and residents to avoid double taxation  Directly reduces U.S. tax liability

6. 16-6 ©2008 Prentice Hall, Inc. Foreign Tax Credit (FTC) (2 of 4)  FTC limited to lesser of Foreign tax actually paid OR foreign taxable income U.S. tax worldwide taxable income x liability

7. 16-7 ©2008 Prentice Hall, Inc. Foreign Tax Credit (FTC) (3 of 4)  FTC deducted after nonrefundable credits  Unused FTC carried back one year and forward ten years on a FIFO basis to a year where taxpayer has an excess credit limitation  Source of income rules on p. C16-6  Used to determine numerator of FTC formula

8. 16-8 ©2008 Prentice Hall, Inc. Foreign Tax Credit (FTC) (4 of 4)  Special FTC limitation  Nine separate baskets of income  Foreign tax credit calculated for each basket of income  See page C16-6 for partial list of baskets  Excess FTC cannot from one basket cannot offset excess limitation amounts in another basket

9. 16-9 ©2008 Prentice Hall, Inc. Foreign Earned Income Exclusion (FEI) (1 of 5)  FEI available to U.S. citizens and resident aliens working abroad  Eligibility  Bona fide resident test  Resident of foreign country uninterrupted for entire tax year and maintain tax home in foreign country

10. 16-10 ©2008 Prentice Hall, Inc. Foreign Earned Income Exclusion (FEI) (2 of 5)  Eligibility (continued)  Physical presence test  Taxpayer must be physically present in a foreign country for 330 full days during a 12-month period, AND  Maintain a tax home in a foreign country during that period

11. 16-11 ©2008 Prentice Hall, Inc. Foreign Earned Income Exclusion (FEI) (3 of 5)  Foreign earned income  Wages, salaries, & fees as compensation for personal services actually rendered  Amount of exclusion  Lesser of  $82,400, OR  Foreign earned income for current year, OR  $225.75 ($82,400/365 days) x no. of qualifying days in current year

12. 16-12 ©2008 Prentice Hall, Inc. Foreign Earned Income Exclusion (FEI) (4 of 5)  Additional exclusion for taxable housing allowance  Limitation lesser of  Actual housing amount included in income, OR  $13,184 ($36.12) x (qualifying days/365)  Housing costs incurred in excess of $13,184 are a for AGI deduction if not provided by employer

13. 16-13 ©2008 Prentice Hall, Inc. Foreign Earned Income Exclusion (FEI) (5 of 5)  Housing allowance exclusion (continued)  Allowance limited to lesser of employer- provided amount or the individual’s FEI  Housing allowance exclusion reduces amount eligible for FEI exclusion  FTC & FEI exclusion are mutually exclusive  Claim either the FTC or the FEI exclusion on foreign earned income, but not both

14. 16-14 ©2008 Prentice Hall, Inc. Taxation of Nonresident Aliens  Resident/nonresident definitions  Investment income  Trade or business income  Calculating US income tax

15. 16-15 ©2008 Prentice Hall, Inc. Resident/Nonresident Definitions (1 of 2)  Resident aliens are taxed same as U.S. citizens  Nonresident aliens generally taxed only on U.S. source income  Taxpayer is a resident alien if they meet one of the two tests

16. 16-16 ©2008 Prentice Hall, Inc. Resident/Nonresident Definitions (2 of 2)  Green-card test  Permanent resident w/ “green card” visa  Physical presence test  Present  31 days during current calendar year AND present  183 weighted average days during a three year period  Current year: 1 day counted as 1 day  Prior year: 1 day counted as 1/3 day  2nd prior year: 1 day counted as 1/6 day

17. 16-17 ©2008 Prentice Hall, Inc. Investment Income (1 of 2)  Most U.S. source passive or investment income is taxed at 30%  30% applied to gross amount  U.S. payer must withhold tax  U.S. payer responsible for tax if not withheld  Tax rate often reduced by tax treaties

18. 16-18 ©2008 Prentice Hall, Inc. Investment Income (2 of 2)  Income exempt from U.S. taxation  Non-USToB capital gains if individual physically present < 183 days during year  Non-USToB interest from banks or other financial institutions not taxed  Portfolio interest  Income from casual sale of personal property

19. 16-19 ©2008 Prentice Hall, Inc. Trade or Business Income  U.S. Trade or business (USToB)  Conducting business in US on regular basis with intent to make a profit  Income exempt from US tax if  In U.S. <90 days/yr, employed by nonresident entity, and earn <$3,000  Real estate income may be treated as USToB instead of passive income

20. 16-20 ©2008 Prentice Hall, Inc. Calculating U.S. Income Tax  Individuals must itemize deductions  Cannot claim standard deduction  Normal deductions apply for items “effectively connected” to a USToB  Gains from real property considered “effected connected” to a USToB  Tax treaties often reduce or eliminate U.S. for many types of income

21. 16-21 ©2008 Prentice Hall, Inc. Taxation of U.S. Businesses Operating Abroad  Domestic corps & Foreign branches  Foreign corporations  Deemed paid foreign tax credit  Controlled foreign corporations  Inversions  §482 rules and tax avoidance  Foreign Sales Corporations & Extra- territorial Income Exclusion

22. 16-22 ©2008 Prentice Hall, Inc. Domestic Corporations  Domestic subsidiary corporations  Can file consolidated return w/parent  Parent protected from foreign creditors of subsidiary  Foreign branches  Income and losses taxed currently  Eligible for direct FTC (described earlier)

23. 16-23 ©2008 Prentice Hall, Inc. Foreign Corporations  If domestic corp owns  10% of foreign corp, domestic corp eligible for “deemed paid credit” for dividends received from foreign corp   10% domestic corp owner cannot claim DRD on non-USToB earnings  U.S. tax on foreign sub’s income deferred until dividends received

24. 16-24 ©2008 Prentice Hall, Inc. Deemed Paid Foreign Tax Credit  Separate basket if own ≥ 10% & ≤ 50%  Called Sec. 902 or 10/50 dividends Div paid to domestic corp (from post 1986 undist earnings All post 1986 undistributed earnings X Creditable taxes paid or accrued by foreign corp (post 1986) = Deemed paid foreign tax credit

25. 16-25 ©2008 Prentice Hall, Inc. Controlled Foreign Corporations (CFC) (1 of 3) Typical tax-avoidance scenario of a CFC U.S. Manufacturing Corporation (Chicago) Foreign Sales Subsidiary (Island Corporation) Foreign Purchasers of U.S. Manufacturer’s Products Billing of tax haven sales subsidiary by U.S. manufacturer Billing of foreign purchasers by tax haven sales subsidiary Physical flow of goods

26. 16-26 ©2008 Prentice Hall, Inc. Controlled Foreign Corporations (CFC) (2 of 3)  CFC definition  > 50% of foreign corp stock owned by U.S. shareholders  U.S. shareholder defined if owns  10% of stock  Some income forms (Subpart F income) of the CFC are taxed in the year in which they are earned  See Figure C16-2

27. 16-27 ©2008 Prentice Hall, Inc. Controlled Foreign Corporations (CFC) (3 of 3)  Tax-deferred earnings can be taxed under Subpart F when invested in U.S. property  Previously taxed income distributed tax-free  Special rules apply to the sale or exchange of CFC stock

28. 16-28 ©2008 Prentice Hall, Inc. §482 Rules & Tax Avoidance (1 of 3)  Tax avoidance opportunity high for domestic parent and 100% owned subsidiary (see slide 16-25)  U.S. parent sells goods/services at less than FMV to 100% foreign sub, OR  Foreign sub pays less than FMV for use of U.S. parent’s intangibles (e.g., patents)

29. 16-29 ©2008 Prentice Hall, Inc. §482 Rules & Tax Avoidance (2 of 3)  §482 authorizes IRS to distribute, apportion, or allocate gross income, deductions, credits or allowances between or among controlled entities

30. 16-30 ©2008 Prentice Hall, Inc. §482 Rules & Tax Avoidance (3 of 3)  §482 Regs hold that transactions between entities must meet arm’s- length standard  Consistent w/ transactions between uncontrolled entities  Comparable transaction under comparable circumstances

31. 16-31 ©2008 Prentice Hall, Inc. Inversions (1 of 3)  U.S. corps subject to U.S. tax on world- wide (WW) income, while foreign corps only taxed on U.S. source income  This encourages U.S. corps with substantial foreign-source income to reorganize in a foreign country through an inversion

32. 16-32 ©2008 Prentice Hall, Inc. Inversions (2 of 3)  Basics of inversions 1. U.S. corp merges into a foreign entity or transfers its assets to a foreign entity 2. Owners of U.S. corp exchange U.S. corp’s stock for equity in foreign entity 3. Same owners continue to conduct both U.S. and foreign business through the new foreign entity, but only U.S. source business subject to U.S. taxation

33. 16-33 ©2008 Prentice Hall, Inc. Inversions (3 of 3)  §§367 & 7874 added to prevent erosion of U.S. tax base  Under §367 a foreign corp (FC) will be deemed to be a U.S. corp if  FC acquired all assets of U.S. corp  Former U.S. corp s/hs own ≥80% of FC &  FC does not conduct much business in foreign country of incorporation

34. Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard.newmark@PhDuh.com 16-34 ©2008 Prentice Hall, Inc.